Today we are answering the question – Is an ETF or a Mutual Fund better for investing in an index fund? In general, ETFs are superior products for index investing for two key reasons: Liquidity and expense ratios. Let’s discuss!
If you haven’t seen it yet, check out my favorite ETFs for passive income in 2024!
What is a Mutual Fund?
A mutual fund is a pooled investment fund that you purchase shares in. Let’s say a mutual fund owns a basket of stocks. When you purchase shares in the mutual fund, you are purchasing directly from the fund managers. The fund managers then take your money and invest it into more stocks, thus increasing the fund value. When you sell, the fund managers liquidate a small portion of the mutual and pay you out your cash. This decreases the fund value. Mutual funds trade once a day after market close and are also only priced once per day after close.
The fund managers then earn fees in the form of expense ratios to compensate them for these activities. These expenses are most commonly in the form of a percent of the net asset value of the fund.
Simple enough, right? Then what is an ETF?
What is an ETF?
An ETF, or Exchange Traded Fund, is very similar to a mutual fund. It is a free-trading fund that invests in basket of stocks, bonds, etc. However, an ETF trades openly on the market and you purchase shares in the ETF from other investors. This means that the ETF is constantly re-priced throughout the day as trades are made.
Like a mutual fund, ETF managers earn fees in the form of expense ratios for managing the fund. But their role is much more limited as they do not need to transact with buying and selling shareholders.
What is an Index Fund?
So we know what a mutual fund and an ETF are, then what the heck is an index fund?!
An index fund is simply an ETF or a mutual fund that mirrors an index. An index is simply an externally developed collection of hypothetical investments. This could be a collection of stocks, bonds, etc. that some financial institution prepares. Examples of an index include the S&P 500, the Dow Jones Industrial Average, or the Russell 2000.
So an index fund is just an ETF or a mutual fund that tracks an index, it’s that simple! The S&P 500 lists out the exact stocks in the S&P 500 each day and their respective weighting. So an index fund just copies that.
Because of this, index funds tend to have much lower expense ratios because they do not have to decide what to invest in. They just follow whatever the index is telling them.
Which is Better for an Index Fund – An ETF or Mutual Fund?
Like I mentioned above, an ETF is superior to mutual funds, in my opinion, for index investing for two reasons: Liquidity and Expense Ratios.
From a liquidity perspective, ETFs have far superior liquidity. With an ETF you can buy and sell an ETF whenever the market is open, with your trade clearing instantly. With a mutual fund, you’re stuck purchasing at an unknown price after market-close. When you want to sell, you are also not completely clear as to your selling price.
From an expense ratio perspective, ETFs almost always have lower expense ratios than mutual funds. They are much easier to administer for the fund managers, and therefore tend to have lower expense ratios. This puts more money in your pocket!
So there you have it! Next time you’re considering an ETF or a mutual fund for your index investing, consider the above!
DISCLAIMER – THIS ARTICLE IS NOT FINANCIAL ADVICE. THIS ARTICLE DOES NOT CONSTITUTE A BUY, SELL, OR HOLD RECOMMENDATION ON ANY SECURITY MENTIONED HERE. THIS ARTICLE CONSTITUTES MY OPINION AND NOT A STATEMENT OF FACT. ALL INFORMATION REGARDING THE FINANCIAL SECURITIES MENTIONED IS ACCURATE AS OF JANUARY 17, 2024. DO YOUR OWN RESEARCH.